JUSTIN FOX: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Justin Fox, and I’m talking today with Nicholas Dunbar, author of The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street and Are Ready to Do It Again.

Nick, thanks so much for taking the time to talk with us today.

NICHOLAS DUNBAR: Thanks, Justin.

JUSTIN FOX: So I’m not getting a really hopeful vibe from the title of your book. You’re saying derivatives remain a powder keg that could bring on another financial crisis?

NICHOLAS DUNBAR: I think there is always a powder keg there when you have complicated financial tools that have scope for mischief in them. That’s not to say that there’s been a great deal that has been done since the crisis to try and make things safer. But it’s only a partial success so far in terms of doing that, and there’s a lot of things that are still lurking in the shadows that could cause problems.

JUSTIN FOX: What financial tools, in particular, are you talking about? You’re not talking about pork belly futures, right?

NICHOLAS DUNBAR: I’m talking about over-the-counter derivatives, and I’m talking about various forms of securitization and financing tools for banks and traders. So these are things like credit default swaps, are the less well-known one, things like the CDOs, the collateralized debt obligations. And there are related things that wouldn’t necessarily obviously be called derivatives, but fall into the category of what you’d call shallow banking. And derivatives are closely linked to that. So it’s the idea of creating an alternative financial system that’s not transparent and unregulated.

JUSTIN FOX: Now, I want to get back to that in a minute. But first I want to establish something, which is that you’re not one of those people who don’t like derivatives mainly because you don’t understand them and the pricing equations behind them. You studied physics at Cambridge and Harvard. Then you were technical editor at the magazine of the derivatives industry, Risk, and now you’re launching a new publication, Bloomberg Risk. So you don’t hate all of these things, do you?

NICHOLAS DUNBAR: No, not at all. And they’re fascinating intellectually. They’re very intriguing, the way that people in the market invent them to solve problems or to make themselves money, which is often the same thing. And they’re very focused on it, and often they mean well in what they’re doing.

But there are certain incentives in the way these things are created and sold that can lead to very suboptimal outcomes, yet risky outcomes for society as a whole. So that’s something that I’ve noticed over the years, and that’s one of the reasons I wanted to write this book.

JUSTIN FOX: So stepping back a little bit, what are some of the useful things, the non-dangerous things that these over-the-counter derivatives can do?

NICHOLAS DUNBAR: They do obvious things for people like hedge risk. So let’s say you’re an airline that’s using a lot of fuel. You might want to buy a contract that’s going to protect you against a rise in oil prices. And big airlines do that every day. They do an enormous amount of that. They also might want to hedge against foreign exchange risk. They’ll buy forward contracts of a foreign currency.

There’s an example I’ve just been looking at here at Bloomberg recently, which is BMW is selling more cars in China than in Germany. And it’s got something like EUR 5 billion of renminbi forward contracts that it’s using to hedge the risk of China’s currency suddenly going down. So it’s hard to say that there’s anything intrinsically wrong with that. It certainly helps give BMW certainty that it wants in order to produce the cars that people want to buy. And what’s the problem with that?

So those kind of derivatives, within reason, they make sense. And as long as they’re regulated, I don’t see how they can be too problematic. But there’s always tweaks of these things and little issues that crop up where you have to keep an eye on them.

JUSTIN FOX: Well, in your book, the way you tell the story, it seems like something went wrong sometime in the past 10 or 15 years. What changed, what happened?

NICHOLAS DUNBAR: Well, one way of looking at it would be to say that what started out as a tool for helping corporations to deal with things in the real world that were worrying them, like commodity price risk or foreign exchange risk, became a way of helping banks to please their shareholders. And I think that was probably one of the most disturbing aspects of it, is the way the banking system got itself onto a treadmill where these tools ended up making the banking system very risky.

JUSTIN FOX: Well, yeah. And in your book, you talk about there being these two mentalities in the financial world, hate to lose and love to win. And I guess banks were traditionally in the hate-to-lose camp, right?

NICHOLAS DUNBAR: Correct. The stereotype of the banker is the conservative figure, the Jimmy Stewart type of community person. And the take on risk is very conservative. And actually, that’s not unusual. It’s pretty much in line with what psychologists observe in most people when they do experiments about their aversions to losing, their unhappiness at losing money. And that creates an approach to risk or approach to uncertainty that means you try to avoid things unless you think the probability of losing is very low, unless the chance you’re going to do badly on the investment is very small.

So there were and there are large numbers of banks and institutions like that around the world that are looking for very safe-looking investments. And what happened was it was the use of derivatives and securitization that developed an industry that became very good at creating things that satisfied those people’s risk preferences, but, in fact, were not as safe or well-constructed as people thought.

JUSTIN FOX: And the people who were designing them maybe didn’t have that hate-to-lose mindset, or the people out there selling them were a different breed than you find on Wall Street, which is the people looking for the big score.

NICHOLAS DUNBAR: Yes, what I call the love-to-win mentality. Now, when you say those words, you think, well, what’s the big deal? It’s just we all love to win, just the same way we all hate to lose. But what I’m getting at with it is that if you have a situation where your downside is covered, then that traditional psychological reflex against uncertainty, against losing, can be diminished.

And derivatives are really important in that, because, in their use as hedging tools, once you are sitting at a trading desk where you can use those things all the time, it helps you overcome that traditional aversion to risk. And you see the world a different way, and that really was my experience with hanging out with people who worked in Wall Street and the City of London. And I just saw a very different viewpoint.

JUSTIN FOX: And how did that play into the craziness that overtook the mortgage market five, six years ago?

NICHOLAS DUNBAR: Well, you could say that what happened, it’s a perversion of the trickle-down concept, if you like, Justin. So it started out that it was only on Wall Street that this mentality existed, and it was the people, the Liar’s Poker types, who were doing this stuff. And the little community banker was still there, and the conservative homebuyer was still there.

And for years and years, academics did research into the way these people thought about things, and they confirmed the stereotype. They were still the same. If you had equity in your home, you would guard it with your life. And the eminent economists did the papers on this.

Then what the trickle-down effect was, you start to have the idea of being able to take the equity out of your house or to be able to refinance mortgages, again, that seemed very useful tools in their own right. But then they start to change people’s psychology, and you have the idea that by selling or refinancing or flipping a house, you’re entering the love-to-win world. You no longer really care about the equity in your home, and then that becomes a trend that sweeps across society. So Wall Street’s doing it, and then Joe Public is doing it, as well.

JUSTIN FOX: And I guess you also get another phenomenon that happens a lot in finance, is you design these risk management tools based on a certain understanding of risk. They go out in the world, affect market behavior, and end up changing the riskiness, as you described. Because of these derivatives, there were these new offerings in home equity loans that caused behavior that ended up causing a worse crash.

NICHOLAS DUNBAR: Exactly. And I think I’d give credit to George Soros, because many years ago, he looked at this idea of reflexivity. But he didn’t really flesh it out. And I found what happened with subprime and the greater credit derivatives really was that in action.

And I suppose there’s one other thing I’d bring in there, which is that as these psychological drivers change, you still have people looking for traditional validation of those conservative beliefs. And then you have organizations like rating agencies which are behind the curve and producing this backwards-looking validation of people’s psychological needs. And then that makes it even more dangerous.

JUSTIN FOX: A side issue that you discuss in the book that’s been in the news a lot lately has been whether Goldman Sachs was betting against its clients on mortgage securities. Was it?

NICHOLAS DUNBAR: It certainly was betting against its clients. But it was doing it in a way that it was hedging its bets against the mortgage market, as well. So it had a big business creating mortgages that it developed over a long time. And there was a character in my book called Dan Sparks who was running that. And that was doing the traditional Wall Street thing of sucking up loans from around the country, bundling them into vehicles, and then issuing bonds against them, and then repackaging them again. And this was the same as a lot of other banks were doing.

What Goldman was very good at is they figured out the way of doing all of this with derivatives so that you could do this in a virtual way or a synthetic way, that you didn’t actually need to buy or sell mortgages anymore. You simply could just write derivatives on them. And that started out as being a great way of investing in subprimes, because you could just buy derivatives that gave you exposure to subprime.

But then what people at Goldman figured out was that, if you were getting people to invest in subprime or the derivative, well, if you were on the other side of the trade, you were betting against the housing market. And, well, once you start thinking that the housing market is going down, then you just simply increase the position that you have against the housing market.

So Goldman has tried to defend itself and said that it didn’t have this big short in place, but the evidence is is that as they simply stopped writing the traditional mortgages– or stopped buying the traditional mortgages, I should say, warehousing them and bundling them– then they, by de facto, became a short-seller of mortgages. They had started betting against it. So by transitioning their business, they ended up betting against their customers.

Whether they were sitting in a dark room rubbing their hands together and conspiring to do it, I don’t know. But their business model and the way they changed their business created the same effects.

JUSTIN FOX: But by transitioning their business, they also protected themselves from becoming another Citigroup or Merrill Lynch, right?

NICHOLAS DUNBAR: Yeah, they did. And they would say they were just the smartest guys in the room. They used this financial technology to protect themselves. But it just happened to make them look evil when they did it.

JUSTIN FOX: Nick, thanks so much for talking with us. That was Nick Dunbar. The book is The Devil’s Derivatives. For more, please visit hbr.org.